One common concern among investors is the lack of income opportunities in the market. Bond yields have collapsed to record lows and offer very little absolute income. In fact most of the treasury curve actually offers negative real returns after accounting for inflation.

As a result, investors have become more and more interested in adding yield to their portfolios through dividends. In many cases dividend income rivals corporate bonds, with the added benefit of potential for growth in the dividend (an inflation hedge) as well as capital appreciation.

Do dividends matter? The short answer is yes. In fact, dividends are consistently a major component of total investor returns through various cycles and periods. A number of studies confirm their significance:

— Dividends add significant value over time. SG Global Strategy research conducted on US data since 1871 suggests that as ones holding period is extended, dividend yield and the growth in real dividends accounts for a greater proportion of total return. Over a one-year period 60 percent of ones total return comes through changes in valuation, effectively price change. However, if you extend your time horizon to a period of over five years, approximately 80 percent of the return is derived from dividends.

— During various economic cycles dividends continue to contribute to returns significantly. In an ISI study conducted on the decades from 1930s to 2000s, dividends averaged 53.8 percent of overall return. In the 1990s this contribution was the lowest at 27 percent and in the 1970s this was the highest at 77.4 percent. In the two decades where equity returns were negative (1930s and 2000s), dividends offered the only positive contribution.

— In low return environments, those where the real returns are less than the long term averages, dividends are a critical component of returns. Using Ibbotson price and total return data for the S&P 500 back to 1926, OShaughnessy Asset Management found that in periods where the ten-year average annual return is less than the overall average, dividends account for 70 percent of total returns. They found similar aspects in the UK where 61 percent of returns came from dividends in a low-return environment.

— Dividends work outside the US as well. Global dividends offer potential return enhancement. OShaughnessy Asset Management also found in looking back to 1970, using MSCI data, that investing in a portfolio of the top decile of dividend-yielding companies produced a 5.7 percent positive excess return versus the market. Putting that in perspective, it is a substantial 43 percent improvement in average annual total return. And the results improve when they expanded their universe even further, using the Worldscope database. From 1988 to 2010, the top decile of the yield portfolio outperforms the market by 6.9 percent on average, a 73 percent improvement in average annual total return. The consistency is impressive as well; the high-yielding decile outperforms the MSCI database in 92 percent of the three-year rolling periods since 1970 and 98 percent of the rolling three-year periods versus the Worldscope database since 1988.

— Dividends help reduce volatility. In a study conducted by Neil McCarthy and Emanuele Bergagnii of Oppenheimer Funds from 1973 to 2010, stocks with growing dividends exhibited a standard deviation of 17.6 percent versus stocks with no dividends which showed much higher volatility at 26.6 percent.

Youre probably saying, this all looks great, but what about taxes. Bermudians are subject to various withholding tax rates from different jurisdictions. Some jurisdictions like Switzerland levy high rates of taxes at 35 percent while other jurisdictions like Japan only withholds seven percent. Obviously if one is serious in pursuing a dividend strategy these withholding tax factors must be considered as they can reduce the cumulative effect of dividends received.

The other concern that is often voiced is that of the fiscal cliff and the potential increase in dividend tax rates. The fear is that higher taxes on dividends lend itself to lower returns from dividend payers. This fear may be unfounded if history serves as a guide. According to Marc Lichtenfeld from the Oxford Club, during the last period of full taxation on dividends, 1985 to 2002, Perpetual Dividend Raisers (those companies with a history of raising dividends for 25 consecutive years) returned 10.6 percent after taxes. The S&P 500 returned 7.8 percent.

One of the larger risks a fixed-income investor faces is outliving the money as inflation and taxes slowly erode ones purchasing power. Equities, on the other hand, can provide at least some hedge against inflation. Bonds seem poised for low single-digit returns and, potentially, negative real returns over time. Dividends offer a significant component of total equity returns during low return environments and over time. An effectively designed dividend strategy not only offers protection of purchasing power but also offers growth of income on a real basis. Quite simply, dividends work.

Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and non-proprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisers prior to any investment decision.

What works in investing - dividends

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